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Price adjustment and exchange rate pass-through

  • Devereux, Michael B.
  • Yetman, James

This paper develops a simple theoretical model that can be used to account for the determinants of exchange rate pass-through to consumer prices. While recent evidence has found low estimates of pass-through in many countries, there is little consensus on an explanation for this. Our paper argues that sticky prices represent a key determinant of exchange rate pass-through. We make this argument in two stages. First, holding the frequency of price change constant, we show that our model calibrated to data from low-inflation countries can reproduce the estimates of very low pass-through for these countries. The principal determinant of low pass-through in this case is the slow adjustment of prices. We then extend the model to allow the frequency of price change to be endogenous. Calibrating to a wider set of countries, including both low-inflation and high-inflation countries, we show that our model implies that exchange rate pass-through is increasing in average inflation, but at a declining rate. Performing the identical exercise on the data, we find a striking correspondence between the predictions of the model and those of the data.

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Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 29 (2010)
Issue (Month): 1 (February)
Pages: 181-200

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Handle: RePEc:eee:jimfin:v:29:y:2010:i:1:p:181-200
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30443

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